What is Double Taxation?

Definition: Double Taxation is an occurrence where the income from the same source is taxed twice before translating into net income. This corporate phenomenon occurs because company income is taxed at the corporate level and taxed again when distributed to shareholders through dividends. In other words, this is a tax policy where the government taxes income when the corporation receives it and taxes the same income again when it is passed on to the owners of the corporation.

What Does Double Taxation Mean?

What is the definition of double taxation? Double tax is the taxing of the same income twice. The most common example of this tax policy is with corporate dividends. As the corporation generates a profit, it pays income taxes at the corporate level. These profits sit in retained earnings until the corporation decides to distribute some of them to the shareholders in the form of a dividend. The dividends given to the shareholders are then taxed as personal income to the individuals. Thus, the profits from the corporation are taxed twice.

Another common example is when the same income is taxed in two different countries during international trade.

Double taxation is unique to C-corporations because of the entity structure. C-corporations are established as separate entities from their owners, the shareholders, and must pay their own income taxes on the profits they generate. When a C-corp passes these profits to its shareholders, the government recognizes that as income to the owners because they are a separate entity from the company. Thus, the shareholders are also required to declare this as income and pay income taxes on it as well.

Although C-corporations have many advantages, this is by far the biggest disadvantage. A shareholder of a C-corp will pay much more in income taxes than if the business was structured as a partnership or sole proprietorship.

Many businessmen and politicians realized this fact and decided to create a new entity that would have the advantages of a C corporation, but could take advantage of the preferential pass-through tax system of a partnership. Thus, the S-corporation was created. This is an entity that consists of the same corporate structure of a C-corp, but is taxed like a partnership. No income taxes are paid at the corporate level and no dividend taxes are paid at the shareholder level. Instead, all of the profits from the S-corporation appear on the shareholders’ income tax returns much like a partnership.

Because of escaping the double taxation problems of a C-corp, S-corporations have become the most common small business entity in the U.S. Larger businesses are prohibited from electing sub S status because no more than 100 shareholders can own an S-corp.

Let’s take a look at an example.

Example:

Tim is the CEO and sole owner of Sterling Company. Sterling generates profits of $100,000 in year one. Thus, at the end of the year it has $100,000 in its retained earnings account. Sterling paid an income tax of 20 percent in year one, resulting in a $20,000 tax bill.

Tim decides that he wants to pay out the $100,000 of retained earnings to himself as a dividend for the year. Thus, he must recognize $100,000 of dividend income on his personal income tax return and pay a 15 percent tax on that money. As you can see, the profits generated from Sterling were taxed twice—once at the corporate level at 20% and once at the individual level at 15%.

Now let’s assume Tim decides to move his company to another country. His earnings in new country are taxed as per the tax structure of the country, but this doesn’t get him out of paying his US income taxes. He must still pay US income taxes in addition to the foreign taxes.

This scenario is also common when someone who works in one country and sends money home to his family in another country. The money is often subjected to income tax tariff of his native.

Summary Definition:

Define Double Taxation: Double income tax means an unintended flaw of the revenue system arising due to different tax structures and legal identities that results in taxation of the income from the same source, twice.